It is ironic that while a derivatives trader can win or lose a fortune in a matter of seconds, the process of trying to sensibly account for those seemingly manic transactions looks set to run for years.
At the end of this month the Accounting Standards Board (ASB) will learn what the finance community makes of its discussion paper (DP) Derivatives and Other Financial Instruments issued in July for comment by the end of October. Those finance directors who count the pages and feel the weight of ASB pronouncements will have been dismayed by the size of the shrink-wrapped package they had to fight to get into and then fight to read.
This DP comes in a folder encompassing three separate document; the DP itself, the appendices and a questions and answers booklet.
While FDs may be appalled by the number of words produced by the Board so far, they can be reassured that there are thousands more to come from the same source on the same subject over the next few years.
While there have been complex financial reporting problems which have been tackled over the last few years – such as off-balance sheet financing and goodwill – it really is hard to think of a subject which has rightly sprung to such prominence in such a short time and presents so many different challenges. Hence the thoroughness of the document.
Corporate financing has changed out of all recognition over the last few years. The use of derivatives such as swaps – an agreement to exchange, in the future, a stream of floating rate interest payments for a stream of fixed rate interest payments – has grown remarkably in the last few years. As companies have increasingly turned to derivatives so the kinds of instruments available has multiplied. But the methods of accounting for these instruments is either non-existent or hopelessly outdated.
In particular, many of these derivatives do not come within a mile of the balance sheet. Or if they do they are shown at a value which completely fails to reflect their true significance. Derivatives are acquired often for minimal or nil cost, yet their value changes rapidly exposing companies to the risk of large profits or losses. Many large companies now use a whole range of these instruments in a bid to actively manage the financial risks they take.
Most FDs are pretty confident individuals who understand their business and its finances through experience and training. But privately a few brave souls will admit they are not up to speed on derivatives and the like, leaving it either to the their in-house treasury team or their external advisers. In the wake of disasters such as Barings this admission may seem foolhardy, but there is very little alternative. Using derivatives is a bit like driving a car. The average driver may not know how to service today’s high-tech computer controlled engines but they can still get their vehicle safely from A to B. Understanding the last bell and whistle of the most arcane derivative is not the point of the accounting and reporting exercise. Knowing how to control it and what it will do is probably the most that can be expected. The ASB’s task is to put a few meaningful controls on the dashboard.
The ASB’s first answer is a quick-fix solution which it wants to see major corporations using straightaway. While it firmly believes that much improved disclosure is not the only answer, it thinks it would help enormously.
The ASB intends to develop the disclosures proposed in the DP into an exposure draft and then an FRS as quickly as possible – which realistically means in the next couple of years. But even before then it has got agreement from the usual list of suspects – the Hundred Group of Finance Directors, the Institute of Investment Management and Research and the London Stock Exchange – to put the squeeze on companies to disclose more about their use of derivatives.
In the longer term the disclosures proposed would enable the users of accounts to assess the risks the organisation has chosen to accept. In theory these shouldn’t be too controversial as they are largely consistent with disclosure already required in the US and by International Accounting Standards. The range of numerical disclosures on items such as the current value of its financial instruments and the effect of using hedge accounting will not make sense to a lot of readers. But companies will be expected to supplement the minute detail with “the big picture”, probably written up in the operating and financial review (OFR), describing the objectives and policies in using financial instruments. The ASB also wants companies to give some indication of market risk. In other words explaining how much would be wiped off the bottom line if interest rates move up by 1%.
FDs may not be keen to add yet more pages to their annual report, especially as they could reasonably argue few will read it and even less will understand, but they have very little choice. What FDs will decide to say in the OFR will certainly make more interesting reading. Who would bet against phrases such as “minimizing risk” and “proper control environment” being at the fore?
Any problems over the disclosure of derivatives will seem as naught compared with trying to sort out the measurement and accounting issues. The principle battleground is bound to be valuation. Once that is sorted out problems such as hedge accounting should fall into place. The DP goes through the various options for the use of cost, current value, or a halfway house, and then sets out its own view. If the ASB had a Statement of Principles (SOP) in place it may feel such a preamble unnecessary. Ultimately its tentative conclusion is that the present historical method of valuing financial instruments is no longer suitable. It argues that using historical costs means substantial assets and liabilities are not reported and reporting gains and losses only when sold means management can manipulate the timings of these realisations. It also argues that active risk management in companies already uses current rates and what is good enough for internal management will do for the rest of us. With the exception of the company’s equity shares, the ASB argues that all financial instruments, both derivatives and non-derivatives, should be measured at current values.
With the wrangle over the SOP still unresolved and fresh in the memory, such a proposal could well start accusations flying again about current cost accounting, despite the ASB’s vehement denials. No wonder it is talking about this one taking several years.
Peter Williams is a freelance journalist.